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February 15, 2012

Financial Literacy Low Among Vulnerable Populations: NBER

Women, elderly least likely to show high levels of financial literacy

While the last few decades have made new products more accessible to “small investors,” this puts undue pressure on investors who are “financially unsophisticated” and may have difficulty understand complex products, according to a working paper from the National Bureau of Economic Research.

How numerate are adults when it comes to calculations related to financial decisions? Annamaria Lusardi, author of the paper, “Numeracy, Financial Literacy, and Financial Decision-Making,” asks.

Lusardi, a professor of economics at the George Washington School of Business and a research associate with the NBER, notes in the paper that in addition to access to complicated products, Americans are also being asked to take greater responsibility for their retirement planning rather than relying on Social Security and pensions to support them. While this provides them with the benefits of greater flexibility and mobility, it also exposes them to financial market risks that were “less evident in the old DB system.”

A review of various studies and surveys taken in the United States as well as in other countries shows that not only is literacy low, it is particularly severe among vulnerable groups such as women and the elderly.

For example, a 2007 survey of early baby boomers, those between ages 51 and 56, asked respondents a series of math questions. Over 80% were able to answer a simple percentage calculation, but only half were able to correctly divide five into 2 million. Just 18% were able to successfully determine compound interest on a hypothetical savings account.

“These are pretty dismal findings, considering the complexities of the calculations involved in many financial decisions,” Lusardi wrote in the paper. “In fact, not just knowledge of interest compounding but even the capacity to do a simple interest rate calculation should not be taken for granted.”

Lusardi notes that young people are relatively financially literate. Almost 80% of people between ages 23 and 28 were able to correctly answer a question about interest earned in a savings account. Among the overall population, though, just 65% were able to choose the right answer.

The 2004 U.S. Health and Retirement Study found that literacy decreases sharply with age. Additionally, in some surveys, women were more likely to answer questions with “Don’t Know” rather than offering an answer, suggesting low financial literacy levels may indicate a “lack of confidence in financial knowledge rather than lack of actual Knowledge.” Lusardi also found that an investor’s family background may play a part in that person’s financial literacy. She found that among 23- to 28-year-olds, financial literacy was strongly correlated with their parents’ education. “In other words, financial literacy may start in the family, perhaps by observing parents’ saving and investing habits or by receiving financial education directly from parents,” according to the paper.

Several studies have shown that investors with greater financial literacy are more likely to participate in financial markets and invest in stocks; they are also more likely to choose appropriate mutual funds. A 2011 study by Lusardi and Olivia Mitchell found that those who can’t do an interest rate calculation were less likely to plan for retirement or accumulate wealth.